Chapter 6 – Cash Flow, Manage It or be Ruled by It

To some people starting a business, cash flow can sound like an obtuse concept.  In fact, ask most business owners to clearly explain it and many can’t.  As misunderstood as it is, cash flow can have more effect on your business than any other factor.  Your success in managing cash flow will influence every part of your business, and being able to successfully manage it will make running your business a whole lot more enjoyable.  So, if you don’t understand cash flow, or even if you do, let’s take a minute to look at how you can make cash flow work for you (instead of against you).

To imagine what cash flow is, I like to think of a leaky bucket.  The water inside the bucket is your cash.  Now, since the bucket leaks, you need to keep refilling it.  Every scoop of water you put in is cash coming in, and every bit of water that leaks out the bottom is cash going out.  If you are able to refill your bucket faster than it is draining, you have positive cash flow.  If you can’t, your cash flow is negative.

Most people think that profitability is the most important thing to pay attention to in their business.  Over the long-term, profitability is hugely important.  After all, the whole point of a business is to turn a profit, and if you are not profitable, you are in trouble.  However, profit can be a funny thing.  You don’t always feel profitability when it waxes and wanes.  That is, your business can be profitable and you can still be broke.  Cash flow, though, is a far more pragmatic force to understand.   You do feel the difference between positive and negative cash flow.  In fact, when this happens, it is usually all over the place in your company’s financials.  So, if you have ever asked yourself why you are not making money even though you are profitable, chances are that your cash flow is the problem.

Cash flow is like the breathing of your business.  There will always be a flow of in and out, and your job is not to try and prevent any cash from ever escaping, but instead to work with the process and manage both sides.  Effective cash flow management usually comes from making smart decisions about what your cash is spent on as well as how to boost the cash coming in.  Taking cash flow into account is not only critical in the day to day running of your business, but it is also incredibly important to take into account when thinking about how to expand your business.  Here is an example:

Let’s say that you have the opportunity to introduce a new product line.  The upfront costs are not too bad, and the profitability is great.  You know that just by spending $50,000 on new inventory you can sell the goods you build from it for over $150,000.  Sounds like a great deal, right?  Well, let’s look at the cash flow.

The first thing you may ask about this scenario is why the $50,000 up front?  Well, it just so happens that your raw material takes a pretty complex process to produce, and so your supplier has an order minimum of $50,000.  This should be ok, right?  After all, you are going to net $100,000 from it.  Slam dunk!  Right?

Well, not so fast.  Let’s look at the cash flow of this decision.  Let’s say that your standard inventory turns (how long it takes to convert a given supply of inventory to sold finished goods) take about three months on normal orders.  This order though, since it is artificially boosted due to the order minimum, is about 10x the quantity that you normally order.  So, you are looking at about 30 months to “turn” this new order.

Over those 30 months, you will have all of the normal expenses that you usually have (rent, payroll, etc.).  Over that time, you also have the sunk cost of the inventory.  And, with your normal rate of sales, you will not even recoup your $50,000 for 10 months.  Over those 10 months, you will have to cover all of your expenses without the $50,000 in cash that you had before you ordered the inventory.  In a nutshell, you paid $50,000 to generate $5,000 per month ($5,000 x 30 = $150,000).  With this long of an inventory turn, chances are that you will gobble up all of your new found profitability just keeping the business going.  That is, with only $5,000 per month of operational expenses, you are barely breaking even.  And if this is the case, you are going to have a really hard time when it comes time to reorder, since you have no excess funds for another $50,000 to come from.

In this example, you have traded profitability for a cash-flow problem.  You have more cash going out than comes in, and you will end up broke.  Sure, the product looks great, I mean who wouldn’t want a 2/3 profit margin?  But that, clearly, is only part of the equation.  We need to look at this from our cash’s perspective and see if we end up with more retained cash than when we had before we started. We need to look at the timing of the cash that will be coming in, along with the timing of the cash that needs to go out.  And by looking at the implications on our cash, we can keep ourselves from making bad decisions.

Since cash has the unique ability to support, or sink, our business, we need to treat it with appropriate respect and care.  To manage your cash, pretend that your business is a bank and you are the banker.  All cash coming in (sales) are deposits, and all expenses are withdrawals.  Looking at your past, have you been a good banker?  Would you store your savings with you?  And, when you look forward, does the future look bright for your little bank, or does it look bleak?

Learning to manage cash retention is probably the most valuable skill you can learn as a business owner.  Because, once you do, your business situation will not only make a lot more sense (you will know why you are broke or not), but you will also be able to predict with reasonable accuracy what the future may hold.  For most people whose businesses have gotten out of control, this latter fact can create tremendous relief.  Because, with cash, you have two choices, either you can choose to manage it, or you can always be wondering why you don’t have as much of it as you should.